How to evaluate a money manager

﻿Overview﻿

Even though the endeavor of evaluating a money manager can seem a daunting task, there are some very simple, basic ideas that can vastly simplify the process without sacrificing the quality of the decision. To be sure, the manager's proposition should be fairly easy to understand and it should be easy to get good and relevant information on the manager (transparency) so claims can be verified.

We offer a few criteria for assessing investment management operations that we believe capture the vast majority of the issues that matter most in differentiating investment quality. The three core concepts of conscientiousness, commitment, and competence are simple, but effective. These general concepts form an overall framework for evaluation and are often "signaled" by more specific metrics. Fund expense, for example, is one specific measure that represents elements of each the three general concepts.

Conscientiousness is the single most important characteristic in our minds. It is the foundation of fiduciary duty – putting the interest of the client first. It often takes a back seat to conflicts of interest, however. As David Swensen describes in his book Uncoventional Success, “The overwhelming number of mutual funds fail to meet the fundamental criterion of fidelity to fiduciary principles, as pursuit of profit overwhelms responsibility to investors.”

There are many indications of conscientiousness and most focus on fidelity to fiduciary principles. The avoidance or forebearance of conflicts of interest, independent ownership, reasonable fees, and sincerely helpful advice are all good signs of conscientiousness.

Commitment is the degree to which the performance and quality of the fund matters to a manager and captures how hungry the manager is to perform. In his book, Hedgehogging, Barton Biggs presents the test: “Suppose the Devil came to you with a Faustian bargain and said: I will have you consistently scoring five [golf] strokes below what you are now if you will give me five performance points from what your fund would have returned over the same time period. Would you do it?” The answer often reveals where the manager is in his/her personal motivation cycle.

Positive signals for commitment include a manager’s co-investment in the fund, investment in the organization, and personal sense of duty to his/her investors. Conversely, low or zero ownership serves as a warning flag because it identifies little economic risk to poor performance. Other warning flags include any signs of significant distraction such as excessively broad responsibilities within an organization, excessively broad obligations outside of the firm, and excessively strong commitments to personal hobbies or activities.

Competence may seem self-evident, but should not be taken for granted. While we are certainly not suggesting anything close to a perfect linear relationship between levels of education attainment and investment performance, it is important to note that unlike many other professions (e.g. law, medicine), there are no substantial formal educational requirements for most investment jobs. Also, importantly, research does indicate a relationship between higher education and more prudent risk-taking.

Obvious things that can help include strong academic backgrounds and CFA certifications. Less obvious things include an investment philosophy that articulates a reasonable and understandable way to generate returns, and transparency which indicates confidence in the process.

SpecificsSizeAll else equal, the smaller a fund or a strategy the better chance it has of performing well. There are only so many terrific investment opportunities at any given time and the bigger the fund, the more it has to invest in less-than-stellar ideas. Size (assets under management, AUM) is often reported in quarterly statements and/or the firm's Form ADV if it is registered.

FeesManagement fees (also known as expense ratios) have regularly been demonstrated to have a significant and negative correlation with performance: The higher the fees, the worse the performance. Fee structures are reported in a firm's Form ADV if it is registered. Be careful, however; it is often extremely difficult to find all of the various costs incurred by a fund.

Active shareActive share measures the degree to which a fund or portfolio differs from its benchmark. Concentration is a good indication of how active a portfolio is. Research shows that while the vast majority of actively managed funds underperform their benchmarks, those with the highest active share actually tend to outperform over time. Combined with fee levels, active share can be used to determine how to get the most "bang for your buck".

Independent ownershipIndependent ownership is one of the strongest signals that a manager's interests are aligned with his/her investors. Ownership interests are also reported in a firm's Form ADV.